IRS Announced Compliance Resolution Program Under Section 409A

02.15.2007

To our Clients and Friends:

On February 8, 2007, the Internal Revenue Service announced an initiative aimed at providing assistance in dealing with certain tax penalties under Section 409A of the Internal Revenue Code for rank-and-file employees who exercised discounted stock options or other stock rights in 2006.  Announcement 2007-18 establishes a compliance resolution program (the “Program”) that allows employers to voluntarily pay on their employees’ behalf the additional 20% tax (plus interest) that such employees or former employees would otherwise owe under Section 409A.  The IRS’s stated goal is to provide relief for employees who may have unknowingly been affected by option backdating practices by their employers.

Companies have until February 28, 2007 to notify the IRS of their intent to participate in the Program.  Affected employees must be told within 15 days of notifying the IRS (i.e., no later than March 15).  By the same deadline, companies must notify the IRS again about the number of affected employees who have been contacted.  Key aspects of the Program are highlighted below.

The relief offered by Announcement 2007-18 is much less than we had hoped for and has elements that will likely make it unattractive to many companies with Section 409A discount option issues.  The Program procedures are cumbersome and must be completed within short time periods.  In addition, an employer who participates in the Program and pays the 20% additional tax and interest on behalf of an employee must treat such payment as taxable income to the employee, subject to normal withholding requirements.  Since employers already were free to compensate affected employees for Section 409A-related tax penalties and interest on a taxable basis if they so wished, the only significant benefit of the Program for employees is the convenience of having their employer calculate and make those payments on their behalf.  In addition, some of the limitations on the scope of the Program as discussed below, limit its usefulness.

Scope of the Program

The program addresses only the 20% additional tax and interest imposed by Section 409A, and the federal reporting requirements related to such taxes, and therefore does not address other non-Section 409A income tax consequences that may arise from the exercise of a discounted stock right, such as the employment tax and reporting consequences that may arise from a failure of a purported incentive stock option to meet the applicable requirements, or the application of Section 162(m) to an employer’s otherwise available deduction for compensation expenses.  The program is also limited to employees who actually exercised discounted options and other stock rights during 2006, and so does not address discounted stock rights that are still outstanding as of the end of 2006.  Finally, the Program does not alter an employer’s tax reporting and withholding requirements arising from the exercise of a discounted stock right, or an employee’s obligation to report and pay the normal income taxes due on the compensation income with their 2006 federal tax returns.

The IRS made clear in its press release accompanying the Announcement that the Program does not involve or affect any other federal agency’s investigations or regulatory action.  The Announcement further noted that the Program does not relieve employers or employees from compliance with any state or local tax reporting or payment requirements.  It is unknown at this time  whether California will offer a similar program to address the 20% additional tax and interest apparently also imposed by that state by virtue of California’s adoption of Section 409A.

Summary of Key Provisions of the Program

• Only discounted stock options or other stock rights (i.e., options or rights with an exercise price below the fair market value of the underlying stock on the date of grant) subject to Section 409A (see below) and exercised in 2006 are covered.

• The program does not permit an employer to pay the additional tax and interest for stock options exercised by its top executives or other Section 16 insiders.

• Employers electing to participate must pay all of the applicable Section 409A-related taxes arising from the exercise of the discounted stock option.

• All amounts paid must be reported by the participating employer as additional compensation income to the affected employee.

• The tax amount due must be paid to the IRS by June 30. Additional interest will be due if payments are received after April 17.

The Announcement detailing the Program eligibility and participation requirements can be found on the IRS’s website at http://www.irs.gov/newsroom/article/0,,id=167643,00.html.  The specific procedures for participating in the Program are not summarized here, but employers interested in participating in the Program should consult the Announcement for the specific procedures and deadlines, or contact one of the attorneys listed below.

Background on Section 409A and Application to Stock Rights

Internal Revenue Code Section 409A was enacted in 2004 and generally applies to compensation arrangements vesting on or after January 1, 2005.  This statute expansively redefined what constitutes deferred compensation, imposed strict requirements on elections made with respect to and distributions (payment) of deferred compensation, and imposed a 20% penalty tax (plus interest) in addition to other applicable taxes on deferred compensation arrangements that do not comply with these strict requirements. 

The IRS guidance to date confirms that the grant of a discounted stock option which vests on or after January 1, 2005 is deferred compensation, and because most options cannot satisfy the distribution timing rules, such options would violate Section 409A.  The prior IRS guidance generally provided that discounted stock options could be corrected in various ways during transition periods that now extend to the end of 2007, though such relief is not available after 2006 for certain Section 16 officers where the grant of a discounted option results in financial restatements by the company.  Furthermore, the IRS has indicated it does not believe correction can be made after exercise. 

Notice 2006-100 issued by the IRS on November 30, 2006 provided guidance to employers on their reporting and wage withholding obligations and guidance to both employers and individual taxpayers on calculating the amounts includible in gross income for 2005 or 2006 with respect to deferred compensation subject to Section 409A.  The IRS has issued several other notices, including Proposed Regulations, interpreting the statute.  Copies of our Updates summarizing the prior guidance are available through our website at http://www.hellerehrman.com/en/practices/pr_exec_news.html

Suggested Actions

Employers should take the following steps immediately in order to evaluate whether it makes sense to elect to participate in the Program:

Evaluate stock option grant practices.  To the extent companies have not yet reviewed their past option grant practices, this should be done as soon as possible to determine whether any grants were made at a discount.  Certain practices, regardless of intention, may be a problem. For example, setting the exercise price of stock grants at the lowest price during a period prior to the date of grant would often involve the grant of a discounted option.  We anticipate that, given the recent heightened scrutiny by the SEC and courts regarding option grant practices, as well as the IRS’s release of Notice 2006-100 in late 2006, many of our clients will have already completed such audits.

Identify exercises in 2006 involving a discounted stock option or right.  Although certain modifications (e.g., extension of the post-termination exercise period) to an option or a determination that an option is not for “service recipient stock” may result in a Section 409A violation, the compliance resolution program only covers exercises of options in 2006 by employees where the exercise price of an option is less than the fair market value of the underlying stock as of the actual grant date.  Because, as noted above, the IRS has indicated it believes exercise of a discounted option prior to correction results in a Section 409A violation, the relief it is now offering provides the employer an opportunity to take the lead on any complex computation issue that cannot be solved by discounted option correction within the transition period expiring at the end of 2007.

Identify whether the affected employees are Section 16 officers.  The IRS relief program is only available to rank-and-file employees.  It is not available with respect to any exercises of discounted stock options by an individual who is (or was) an executive officer or other insider subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934 as of the date of exercise or the date that the company elects to participate in the Program.

Seek advice on implications of participation in the Program.  Because the Program carries with it certain notification obligations to employees and reporting obligations to the IRS, and requires that a participating employer make certain representations to the IRS under penalty of perjury, companies should consult with legal counsel about the ramifications of participating in the Program, especially in light of other stock option related inquiries that may be underway.  For example, a participating employer is required to notify all employees whom it reasonably anticipates are affected by the employer’s participation in the Program.  A participating employer will also be expected to provide detailed information about the discounted options, including the tax calculation sufficient to allow the IRS to determine that the Treasury receives all taxes owed, and to represent under penalty of perjury that it made reasonable, good faith efforts to identify and report to the IRS all exercises of discounted stock rights in 2006 (applying a reasonable, good faith interpretation of Section 409A), and has accurately calculated and paid the applicable Section 409A-related taxes.

IRS Circular 230 Disclosure:  To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalty or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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